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Why I think the Vodafone share price could double your money

Nobody can have been too surprised when Vodafone (LSE: VOD) announced last week it was rebasing its dividend. My colleague Harvey Jones was doubtless echoing the thoughts of many, when writing, I guess it had to happen, sooner or later.

Just over a year ago, Vodafone agreed an €18.4bn acquisition of Liberty Global‘s operations in Germany and Eastern Europe. With it also facing several years of elevated investment to acquire 5G spectrum, it was always going to be touch-and-go whether its cash flows and balance sheet would be strong enough to maintain a €4bn-a-year payout to shareholders.

Over the last year, the market became increasingly convinced the dividend was unsustainable. The share price declined relentlessly, pushing the yield up towards double-digits, in the classic telltale sign of a market pricing-in a cut.

In an article last month, I suggested Vodafone’s valuation was so depressed that investors would ultimately be handsomely rewarded, whatever the dividend outcome. Today, I’m even more optimistic the stock has the potential to deliver terrific returns.

Rio precedent

Last month, I drew a comparison between Vodafone, and fellow FTSE 100 giants Shell and Rio Tinto, which had similarly been priced for a dividend cut a few years ago. Shell bucked the market by maintaining its payout, but Rio did a rebasing.

On 10 February 2016, the day before Rio’s annual results, its share price was 1,765p. The yield on a hoped-for maintained dividend of $2.15 (148p at the prevailing exchange rate) was 8.4%

The following day, the company announced it planned to rebase the dividend to not less than $1.10 (76p) — a cut of up to 49%. The shares fell 3.4% on the day to 1,705p, giving a forward yield of 4.5%

Today, the share price is 4,673p, which means buyers of the stock on the day the dividend cut was announced have seen the value of their holdings increase 174% in a bit over three years. Add 837.46p of dividends, and the total return comes to 223%.

Scope to double

Let’s look at Vodafone’s rebasing. Last Monday, the day before its annual results, its shares closed at 131.78p. The yield on a hoped-for maintained dividend of €0.1507 (13.1p at the prevailing exchange rate) was 9.9%.

The following day, it announced it would be rebasing the dividend to €0.09 (7.8p) — a 40% cut, similar to Rio’s. The shares fell 3.7% on the day (also similar to Rio’s), giving a forward yield of 6.1% at a price of 126.84p.

Now, it’d be a stretch to expect Vodafone’s return over the next three years to match Rio’s of the last three, but I do see scope for the telco’s shares to double. After all, they’ve been above 250p within relatively recent memory.

Very cheap

For the company’s current financial year (ending March 2020), management has guided on free cash flow (FCF) of “at least €5.4bn.” This equates to around 18p a share at current exchange rates and with 26.75bn shares in issue. At Friday’s closing price of 124.28p, we’re looking at a valuation of 6.9 times FCF, or an FCF yield of 14.5%.

This is very cheap, in my book. If the company executes well on its plans to grow FCF, I think the cheap FCF rating and depressed share price will be distant memories in a few years’ time. As such, I’d be happy to buy the stock at today’s level.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.